Step Up and Place Your Bets on a Resource Showdown!

Let’s play a game this week. The game is going to be a bit like the America’s longest-running game show, The Price Is Right.

I’m going to show you two items for purchase.

You have to tell me which of them is more expensive.

Ready?

Good, let’s go….

Item 1 — The combined market capitalization of four technology heavyweights: Facebook, Microsoft, Amazon and Google.

Four big and successful companies, to be sure. Now, I want you to tell me if those four companies are more expensive than…

Item 2 — The combined value of every energy company in the S&P 500.

Whoa, that is a lot of stuff… Item 2 must come in a very heavy box.

Let me provide a little more color on what Item 2 includes so you know what it is all about.

Item 2 has each and every energy company listed on the S&P 500. They are:

Anadarko Petroleum Corp., Apache Corp., Baker Hughes Inc., Cabot Oil & Gas A, Cameron International Corp., Chesapeake Energy Corp., Chevron Corp., Cimarex Energy Co., ConocoPhillips, CONSOL Energy Inc., Denbury Resources Inc., Devon Energy Corp., Diamond Offshore Drilling, Ensco plc, EOG Resources, Exxon Mobil Corp., FMC Technologies Inc., Halliburton Co., Helmerich & Payne Inc., Hess Corp., Kinder Morgan Inc., Marathon Oil Corp., Marathon Petroleum Corp., Murphy Oil Corp., Nabors Industries Ltd., National Oilwell Varco Inc., Newfield Exploration Co., Noble Corp., Noble Energy Inc., Occidental Petroleum, Peabody Energy Corp., Phillips 66, Pioneer Natural Resources, Range Resources Corp., Rowan Cos. Inc., Schlumberger Ltd., Southwestern Energy Co., Spectra Energy Corp., Tesoro Corp., Transocean Ltd., Valero Energy Corp., Williams Cos. Inc.

That is a list of 42 companies. All of them are big. Some of them are massive (Exxon, Chevron, Conoco, Schlumberger).

So what do you think? A search engine, a software provider, a book seller and whatever Facebook is… versus 42 giants of the energy sector.

Which is more valuable?

As of Oct. 30, 2015, the score was…

AMZN + GOOG + MSFT + FB = 7.9% of the S&P 500.

The 42 energy companies above… only 7.1%.

How can that possibly be?

These energy companies provide the essential input that allows global economies to run. The energy that they supply allows businesses to function. It is an absolutely crucial part of our agriculture system, which helps feed the world.

Trust me, the world could do without Facebook. We don’t need to snoop into the latest vacation photos of that ex-girlfriend we haven’t seen since college.

But we do need to eat. And we need our economies to run. We can’t do that without energy companies.

Energy is crucial, yet these 42 world-class companies have a lesser valuation than four companies that didn’t exist in any meaningful way 30 years ago.

Let’s have a look…

Today, These Valuations Aren’t Wrong

I’m a big fan of Warren Buffett’s approach to investing. Remember, this is a man who invested his way to tens of billions of dollars. And not just on one great investment, but on the back of repeated successful investments.

What I like specifically about Buffett is how he takes the complex and makes it very simple.

According to Buffett, the value of a business or an asset is the future value of all of the cash flows that it will generate discounted back to a present value.

That, my friends, is the very essence of why the valuations of these energy sector companies are so compressed today.

At current energy prices, the future cash flows that these companies will generate are pathetic. On new wells being drilled, there is actually no positive cash flow.

For the producers, most of the future drilling opportunities that they have don’t work at $45 oil. Yes, they have legacy production that can generate positive cash flow at current commodity prices. But as far as generating full-cycle profits drilling new wells… well, forget it.

For the service companies, the picture is equally grim if the future looks like the present. If the producers can’t make money drilling, then they aren’t going to drill — both because they don’t want to and because they aren’t going to be able to afford it.

No cash flow means no money to invest in new wells.

Which is exactly why the status quo can’t persist.

The price of oil doesn’t work for anyone who produces oil.

It doesn’t work for offshore deep-water producers. That is why we are seeing those projects being cut left and right.

It doesn’t work for oil sands producers. There is talk up here in Canada that there may never been another oil sands project greenlighted.

It doesn’t work for shale companies. With today’s economics, the U.S. rig count has dropped from 1,600 to 578.

And it most certainly doesn’t work for the Saudis or any of their OPEC colleagues who have intentionally ramped up production in an effort to fight for market share.

Yes, the Saudis have been successful in stopping U.S. production growth, but they aren’t having any fun doing it. They are burning through their cash reserves at an alarming rate… $70 billion so far this year.

The IMF warned this week that Saudi Arabia will run out of cash before 2020 without a significant rebound in oil prices.

Add it all up and it’s no wonder that the energy component of the S&P is struggling. But while the market value for these companies isn’t “wrong” — I don’t think it will last. The market is valuing these companies as though $45 oil is here in perpetuity… that is not going to be the case.

So where to from here?

Well, I think the Saudis are crazy if they don’t ease off the gas pedal fairly soon. They have already stopped the growth of U.S. shale and reintroduced fear into the minds of the bankers that financed the U.S. oil boom.

Saudis aside, there’s another reason to expect the oil market to rebalance: demand. Production globally outside of OPEC is declining, and demand has surged. Even the IEA is forecasting for 1.8 million barrels of growth in demand in 2015 now.

The oil market is rebalancing, slower than I expected, but it is happening.

If the Saudis had just done nothing this year, oil prices would have already rebounded. Instead, the Saudis surprised us all and actually increased production. They can’t do that again. They just don’t have the capacity.

You Can Buy the Energy Companies in the S&P 500 Index

Today, the market values four tech heavyweights at a richer price than 42 of the world’s greatest energy companies.

Which is the better bargain today?

The Facebook/Amazon/Microsoft/Google combination? Or the 42 energy blue chips?

My money is on the latter. Rising oil prices will force the market to revalue these companies.

I feel very comfortable with the idea that over the next 24 months, the energy sector will outperform the overall market once again.

Keep looking through the windshield,

Jody Chudley

The Daily Reckoning